Educational Articles

Industry Analysis: Restaurant

Matthew E. Spencer

Restaurant companies are essentially retailers of prepared foods, and their operating performance is influenced by many of the same factors that affect traditional retail stores. For the most part, restaurants have business models that are relatively easy to understand, and the array on the Value Line page is the same as that of a standard industrial company. Nonetheless, there are a number of unique factors to consider when making investment decisions regarding this large and segmented industry.

Competition between restaurants is intense, since dining options abound. And, while there are certainly dominant players in this industry (especially among fast-food purveyors), no one company has the market cornered. Indeed, virtually every restaurant location must compete not only against other publicly traded chains, but also a wide array of small, local establishments. Competitors include everything from delis and pizzerias to fine-dining restaurants. And, of course, it is relatively easy to forgo prepared foods, altogether, in favor of home cooking, which is usually a less expensive option. Thus, restaurant meals are discretionary purchases, and the industry tends to be highly cyclical.

Sales

Top-line growth is typically generated in two ways, opening locations and boosting same-store sales. Opening new doors is a straightforward strategy, and usually the main driver of revenue when a company is in its early stages. As a chain grows in size, however, it becomes increasingly difficult to capture benefits. The best, most profitable locations are established first, and then managers must be careful not to place restaurants too close together, lest they cannibalize each other's sales.

Comparable-store sales, or "comps", is a valuable metric to examine when analyzing restaurants. Comps are particularly important once a company reaches maturity, since they become the primary driver of growth. Product innovations and menu-price increases are two of the most common ways to increase same-store sales. Remodeling existing locations is another way to boost guest traffic. Furthermore, promotions and limited-time offers are widely used to attract diners. Investors should also pay attention to trends in the dollar value of the average guest check, as this can shed additional light on what exactly is driving sales.

Margins

Management's execution and ability to deliver a menu that appeals to a wide range of palates go a long way toward determining a restaurant's margins. Most companies in this industry have operating margins in the mid- to upper teens, and net profit margins in the mid- to high-single digits. Food costs are obviously an important line item and, at times, can fluctuate wildly. Prices for staples, such as corn, chicken, beef and dairy, can move greatly, depending on factors like crop yields, feed costs and other external demand factors.

Labor is another major cost for service-oriented restaurants. Typically, workers earn modest salaries, often at or just slightly above government-mandated minimum wages. Employees that fall into this category are usually fast-food workers, dishwashers and bus boys. Servers, who make the lion's share of their money through tips, are usually paid even less. Consequently, changes to federal or state minimum-wage laws can have a noticeable impact on a restaurant's costs and margins.

Fast Food vs. Casual Dining

Restaurants can be loosely broken down into two broad categories: fast food and casual sit-down establishments. The same general factors discussed above dictate the performance of each group, but sit-down restaurants tend to be more expensive, making them even more sensitive to consumer budgets and the health of the economy. Fast-food restaurants, being less dependent on macroeconomic conditions, are better defensive investment plays. In a recessionary environment, their convenience and value make them attractive options for diners seeking inexpensive meals or for those trading down from casual-dining establishments.

Convenience is a major part of the fast-food business model, so a vast network of stores is essential to success. In addition to expansive hamburger chains, there are a number of large players that focus on niches, such as sandwiches and pizza.

Fast food is responsible for most of the industry's international sales. Foreign markets offer vast growth potential for companies willing to take on the challenge of finding a successful formula that appeals to a wide array of customs and tastes. A well-know brand name provides a huge leg up when expanding overseas, which is one reason why fast-food makers dominate the international arena. The convenience of these restaurants and their typically inoffensive menus, which appeal to most diners, are other pluses.

Investment Considerations

Restaurant stocks have a number of attractive attributes. Their business models are easy to understand, as are the factors that effect their performance. Most are cyclical, so broad economic conditions often play an outsized roll in the group's overall performance. However, fast-food retailers can sometimes provide more shelter in a down economy. Conservative investors might find the stocks of mature operators appealing as growth-and-income holdings. Conversely, fledgling companies, with new or unique formats, use most of their cash flow for expansion, and their stocks may offer attractive 3- to 5-year appreciation potential to the more venturesome.